Debt Equity Ratio: Meaning, Formula, Importance

Debt – Equity ratio Meaning

The debt-equity ratio is an indication of the relationship between the contribution of the creditors and shareholders /owners in the capital employed in business. It’s one of important financial liquidity ratios among all that are used to assess the performance of a company.

Debt – Equity ratio Formula

DER = Total amount of Debt/Total equity funds

It expresses the extent to which shareholder’s equity can meet a company’s obligations to creditors in the event of liquidation of its operations.

For example if the total amount of liabilities of a company is 15 crore rupees where total equity amount is 10 crore rupees.

DER = 15/10. =1.5 times or 150%

It means for every 1.5 rupees of lenders there is only 1 rupee amount of equity funds to compensate the creditors.

Points to be considered while calculating DER :

1.It’s required to know that there are many ways to find the debt-to-equity ratio So it is important to be clear about the type of debt and equity are being in operation in an entity when using it to analyse the performance.

2. Sometimes amount raised through issue of preferred shares is considered as debt rather than equity while calculating Debt Equity ratio because this amount must be repaid to preference share holders at the maturity of time period mentioned previously at the time of issue.

Importance of Debt – Equity ratio

1.When the Debt Equity ratio of a company is very high then it’s an indication that the company’s operations are going in vain in generating enough funds to meet the fixed financial obligations ie debt.

2.When the Debt Equity ratio of a company is too low that means the company is failed in getting the benefits from financial leverage.

3. When comparing the Debt Equity-ratio of two or more companies ,we should ensure that they are belonging to similar industry because comparison of different companies of different industries can’t depict a more accurate results. For instance Labour intensive industries requires less amount of capital when compared to other. So obviously it has a greater impact on debt equity-ratio of the companies belonging to such industry.